Investing in stocks in a 401K is actually quite simple. The reason is that, unlike a traditional brokerage account where your investment options are nearly limitless, your choices of investments are usually fairly limited in your 401k. The secret is simply to create an account with as much diversification as you can and then maintain that diversification.
Step 1: Selecting a Contribution Amount
When you start working Human Resources will send you a form, along with all of the packet of other forms, on which you specify your 401K contributions. Typically one defines a percentage of your pay to put away each month.
You should be contributing about 15% of your pay to retirement. This will allow you to save enough to replace your income in retirement without depleting your resources. Using the different accounts available, here is how you should allocate that 15%:
1. Fund your 401K up to the amount that the company matches.
2. Fund an individual IRA up to the limit.
3. If you have money left over, fund your 401K up to the limit.
4. If you still have money remaining (lucky you) fund a private investment account.
Step 2: Selecting Initial Investments
In contributing to your account, you typically specify the percentages of your contributions which go to each fund each month. You can also periodically redistribute the funds you have built up among the different funds. You should spread your contributions out to different investment types. This provides stability, since one sector of the market will typically do well when others are doing bad. The types of funds available will vary, but something like the following should be used:
20% Large Cap Stocks
20% Mid Cap Stocks
20% Small Cap Stocks
10% Aggressive Growth
20% Bonds, or a growth and income fund
Another asset allocation would be by the fund’s investment strategy instead of by company size. An allocation in this scenario might look like this:
10% Aggressive Growth
20% Growth and Income
Note that if there are more than one choice of funds in each category, choose the fund types that charge the lowest fees. Index funds or Index ETFs are ideal for their low fees. Looking at fund return history may seem like a good strategy, but funds rarely repeat past performance. By buying a fund that has done well you are actually increasing your chances of buying a basket of stocks that are high in price.
Step 3: Rebalancing
During any span of time some funds will do better than others. For this reason, about once a year, you should rebalance your portfolio.
In doing this, exchange securities until your assets are allocated again according to your strategy. This means you will be selling shares of funds that have done well and buying shares of funds that have done poorly. You are therefore selling high, locking in profits, and buying low while the funds are at a discount. Often your 401K plan will allow you to simply specify the percentages you will have in each fund and the needed sales and purchases will be done automatically.
For example, if you originally setup your portfolio as specified in the first example above and large caps have a great year compared to small caps, your allocations may look like this after the first year:
Large Caps: 30%
Mid Caps 18%
Small Caps: 15%
Aggressive Growth 12%
Growth and Income: 17%
You would reallocate until your allocations matched your original plan.
Step 4: Unwinding
As time passes you should start to unwind your account, generating cash and moving more assets into income producing funds. In particular, when you are about 10 years from retirement you should start raising cash in your 401K.
You should have 5-10 year’s worth of cash when you retire, so the first step is figuring out how much you will need to pay expenses including food, utilities, hobbies, travel, and medical expenses in retirement. You should perhaps move between 1/2 and 1 year’s worth of expenses from your portfolio into a money market fund in your 401K each year.
Note it also makes sense to pay off any remaining debts you have when you enter retirement. The security of having ownership of your house and a lack of car payments are well worth the expense. Ideally you should save and pay these debts off quickly using your working income, but as a last resort using 401K money to retire these debts might be advisable. Just remember that you will be paying taxes on the distributions, so plan distributions carefully with your CPA.
If you have a significant amount of money in your 401K, which you will have if you started early, you will be able to get by with less cash since you’ll have enough cushion in your account to handle market swings. In this case you will want to shift a good portion of your assets into interest paying funds (bond funds, utility funds, etc….) Ideally you will set up the account such that the dividends and interest you receive each year will exceed your living expenses.
In this way, as long as the funds continue to pay the needed interest rates, you will be able to meet living expenses without needing to sell shares. The price fluctuations of the shares will become immaterial at that point. Some buffer of cash should be kept even in this case, however, just as added protection in case unexpected expenses occur.
Managing your 401K is really not the daunting task it seems to be. The keys are diversification and periodic reallocation.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.